1. Lecture 4 The Maximizing Bureaucrat Prof. Dr. Johann Graf Lambsdorff Anticorruption and the Design of Institutions 2008/09

2. ADI 2008/09  Lambsdorff, J. Graf (2007), The New Institutional Economics of Corruption and Reform: Theory, Evidence and Policy. Cambridge University Press: 58-80. Literature

3. ADI 2008/09  Where market distortions exist, public servants seek to make rules vague and complex so that they are provided with bureaucratic discretion.  Once market distortion and bureaucratic discretion go hand in hand, reform becomes a daunting task.  Those who profit from corruption will oppose reform.  Corruption would not be the result of inefficient regulation but its cause. The Request for Bad Regulation

4. ADI 2008/09  Public servants have an incentive to keep inefficient regulation.  They will oppose attempts to get rid of regulation.  Regulation may even be initiated with the purpose of creating corrupt income.  Corruption and market restrictions can be two sides of the same coin.  In this case the causality is reversed: Prospects of corrupt income can be responsible for the creation of inefficient regulation.  A corrupt civil servant then regards his public office as a business, the income of which he will seek to maximize. The Request for Bad Regulation

5. ADI 2008/09  In return for the exclusive right to import gold, a private businessperson offered bribes to the Pakistani government. In 1994 the payment of US $ 10 million on behalf of Ms Bhutto's husband was arranged and a license to be the country's sole authorized gold importer was granted.  The Abacha family was behind the operations of the firm of Delta Prospectors Ltd., which mines barite, an essential material for oil production. Shortly after Delta's operations had reached full production, General Abacha banned the import of barite, turning the company into a monopoly provider. The Request for Bad Regulation

6. ADI 2008/09  Allegations concerning a son of the minister of the interior in Saudi Arabia: he established a chain of body shops for car repairs. Afterwards he engaged his father to obtain a decree by the king, imposing a requirement for the annual inspection of all 5 million cars registered in Saudi Arabia.  Twin currency system in South Africa was officially aimed at providing foreign currency to investors. But the parliamentary commission entitled to distribute the cheaper currencies was said to request favors in exchange. Abolishing this system was long impeded by the commission's influence on parliament. The Request for Bad Regulation

7. ADI 2008/09 The Vicious Circle The Request for Bad Regulation Low quality of instutions; bureaucratic discretion; improper government intervention Corruption

8. ADI 2008/09 Myrdal [1956: 283]: ”In many underdeveloped countries... the damaging effect [of quantitative controls] have been serious. The system tends easily to create cancerous tumors of partiality and corruption in the very center of the administration, where the sickness is continuously nurtured by the favors distributed and the grafts realized. Industrialists and businessmen are tempted to go in for shady deals instead of steady regular business. Individuals who might have performed useful tasks in the economic development of their country become idle hangers-on, watching for loopholes in the decrees and dishonesty in their implementation.” The Request for Bad Regulation

9. ADI 2008/09 The Maximizing Bureaucrat Supply Demand Price of Imported Good Quantity of Imported Good Demand for Entitlements Quantity of Entitlements Bribe Maximum bribe Marginal Revenues of Monopolistic Bureaucrat Optimum Quantity Optimum Bribe Quantity Restriction or Maximum Price Minimum Price or

10. ADI 2008/09  The bureaucrats and politicians who are helpful in circumventing regulation may be the same who fight for their endurance or put them in place.  Corruption can therefore be worse than distorting state intervention into markets.  It cuts red tape but brings about even larger inefficiencies.  Only in the case of very large pre-existing distortions there is a net benefit from corruption.  Casual arguments that corruption can be beneficial relate to a rare incidence: the existence of government intervention that is totally irrational. The Maximizing Bureaucrat

11. ADI 2008/09 The case of beneficial corruption The Maximizing Bureaucrat Effective Maximum Price Price of Housing 0 Quantity of Housing Supply Demand Q1DQ1D Excess Demand Q1SQ1S Income from Bribery Supply +Entitlement Maximum Bribe Income

12. ADI 2008/09 Look, I want to announce some rigid rules and regulations — so that I may liberalise them to give relief to the people! Laxman, Times of India The Maximizing Bureaucrat

13. ADI 2008/09  After more than 12 years of doing research on corruption the cases of beneficial corruption I collected are extremely rare.  A prison warden in Nigeria took bribes for passing on a prisoner’s letter to the international media, describing the inhuman treatment. He was detained and his further fate not reported.  The movie “Schindler’s list” well illustrates another case: freeing Jews from Nazi camps sometimes involved the payment of bribes.  These rare cases have been given too much attention by academia and business.  These cases may be as numerous as cases of beneficial murder – too little to adjust the law. The Maximizing Bureaucrat

14. ADI 2008/09  The principal-agent approach provides an alternative concept of the adverse welfare effects of corruption.  Fighting corruption can be costly.  The principal must devote resources to the fight against corruption. There are expenses for detection, enforcement and incentives.  If these costs become too large, a certain level of corruption becomes unavoidable.  This calculus can be graphically illustrated. A Principal Agent Approach

15. ADI 2008/09  Marginal costs of removing corruption are higher where there is little corruption. This might be due to increased difficulty of detection.  Marginal costs of corruption might have any slope, positive or negative. A Principal Agent Approach Marginal social costs 0 Quantity of Corruption Marginal cost of corruption Marginal cost of removing corruption Optimum quantity of corruption Optimum social costs of corruption Additional social costs of eradicating corruption

16. ADI 2008/09  With corruption at an optimum level, should we stop worrying?  No, there are still welfare losses. The principal is in charge of delegating a task to the agent and may decide against this.  If costs of corruption are too large, they make the whole delegation unprofitable to the principal. The principal will thus prefer to cancel the whole project.  Both principal and agent suffer if the optimum level of corruption is too large.  Corruption implies that potentially beneficial contracts are no longer tenable.  Those contracts that require honesty and the absence of corruption will not be sealed when the principal faces an agent who will take advantage of the arising opportunities. A Principal Agent Approach

17. ADI 2008/09  When agents cannot credibly promise to reject side-payments from clients, they are not trustworthy when writing contracts that require the absence of such payments. Principals will be reluctant to offer such contracts in the first place.  An illustrative example on this is provided by Bates [1981]. He argues that in Sub-Saharan Africa peasant farmers avoided corruption by taking refuge in subsistence production. They simply avoided exchange with those who might extort them. The welfare enhancing profits from a division of labor could not be achieved because farmers had no guarantee that they would not be cheated.  It may be worthwhile to construct good-quality roads. But principals may choose to cancel the project if bad quality is expected to result from unavoidable collusive behavior. A Principal Agent Approach

18. ADI 2008/09  A fair and efficient tax system is desirable. If tax collectors cannot be kept from taking bribes such a system may fall into disfavor and be terminated by the principal.  The citizenry prefers to vote against tax hikes because administration and politics cannot be kept from embezzlement.  Supervisors may be unable to guarantee honest reports that are not influenced by bribes. Their contribution loses value for the principal and they may not be hired in the first place.  Ultimately, those agents who are willing to take bribes must bear the burden of the drop in welfare.  Only those jobs survive for the agents where profits for the principal are huge and where social losses due to corruption small. A Principal Agent Approach

19. ADI 2008/09 Source: The Wizard of ID, Parker and Hart, April 9 2000 A Principal Agent Approach

20. ADI 2008/09  In this perspective, the maximizing bureaucrat is no longer maximizing.  His actions can be anticipated; his superior (the principal) has no reason to trust in his loyalty.  The bureaucrat (the agent) will not be hired in the first place.  Any new agent must resist the temptation provided by their discretionary power.  If an agent can commit to honesty, he will be preferred and given the job.  Commitment to such a mechanism provides agents with a competitive advantage. A Principal Agent Approach

21. ADI 2008/09  Bureaucrats want to resist temptation. They need help in this desire, just as anonymous alcoholics need their peer group to support their integrity. Reform may find support among the bureaucracy, even if it cuts down on the capacity to take bribes.  We have allies everywhere in the fight against corruption. There is honest willingness to contain corruption, except among those who have not adequately thought about the problem.  Some economist’s have suggested that corruption is just as natural as self-seeking. I suggest the opposite: the quest for integrity is part of human nature. A Principal Agent Approach

22. ADI 2008/09  Even those bureaucrats who are willing to take bribes have an intrinsic motivation to commit to honesty. They seek methods for guaranteeing the absence of corruption in order to be hired in the first place.  Anticorruption can cultivate bureaucrat’s willingness to commit to honesty by advancing professional ethics and anticorruption networks.  Ideas for anticorruption need not be sought by the government, they may be implemented by bureaucrats themselves. Hints for Reform A Principal Agent Approach

23. ADI 2008/09  Countries with a large public sector (contrary to some economists’ belief) are not characterized by more corruption. Thus, it is not the size of government that counts. This is largely due to the fact that overall revenues decline with corruption.  How can declining public revenues in corrupt countries be explained? This may be due to the rational just developed. Citizens (the principal) prefer tax cuts where bureaucrats (the agents) fail in committing to honesty. A Principal Agent Approach

24. ADI 2008/09 Discussions: 1) How does bureaucratic discretion affect the behavior of public servants? 2) On June 20, 2001, Reuters ran the following news: …Argentina now has two exchange rates -- one for domestic transactions that Argentines will use when they buy groceries or pay rent where one peso equals one dollar, and another for trade that applies only to exporters and importers. Under this new system, for instance, a grain exporter would receive 1.0748 pesos for every dollar sold abroad, raising the grain exporter's revenues and making his goods more competitive in markets like Brazil and Europe. But experts say the measure -- which amounts to a 7 percent subsidy for exports and a tax on imports -- is a form of capital control that creates massive opportunities for corruption. Explain why this system may invite for corruption! 3) How does a regulated market compare to one where public servants maximize income from corruption? 4) Explain why corruption may be a cause of market distortions! 5) Why may a maximizing bureaucrat fail to maximize? Explain by use of a principal-agent approach! Appendix

25. ADI 2008/09 Exercise: The market for import of gold is characterized by customer’s willingness to pay: p=40-2x and the suppliers’ cost function K=x2. Assume perfect competition. The market is restricted and bureaucrats are able to sell entitlements to import, charging a fixed fee (b) relative to the quantity imported. a) The bureaucrats provide entitlements for free. Determine the resulting amount of imports (x)! b) The bureaucrats determine b so as to maximize their revenue. Show that imports as determined in a) drop to half the original amount. c) Show for a more general cost function K=a+fx2 that the fee (b) is independent of marginal costs. Interpret this outcome economically! Appendix